There is no agreed definition of a hedge fund.

[FaGal]

INVESTMENT TERM FOR WHICH THERE IS NO AGREED DEFINITION There is no agreed definition of a hedge fund.
news.ft.com - By Kate Burgess - March 11, 2005

INVESTMENT TERM FOR WHICH THERE IS NO AGREED DEFINITION - There is no agreed definition of a hedge fund.


But in general they are characterised as unconstrained, actively managed funds, writes Kate Burgess.

Unlike mutual funds such as unit trusts, hedge funds can go short - that is, sell stock they do not own - borrow heavily, use dynamic trading strategies and aim to pay positive returns even when markets fall.

They are also characterised by high fees of at least 2 per cent a year with performance fees typically at 20 per cent and more.

Hedge funds operate largely outside the main regulators' supervision.

The hedge fund managers, most of whom work from the UK or US, are authorised by the US or UK regulators.

But the funds themselves, which are based offshore to minimise the tax liabilities for both the fund and the investors, are unrestrained.

However, hedge funds are increasingly difficult for regulators to ignore.

There are now thought to be about 7,000 to 8,000 worldwide, controlling almost $1,000bn (£520bn) of assets.

That is small by comparison with the $30,000bn-$40,000bn invested in mutual funds.

But hedge funds wield increasing power over markets and market participants.

The first hedge fund is said to have been set up by Alfred Winslow Jones, a US fund manager, in 1949.

He borrowed to enhance the returns from his portfolio, and used short-selling to "hedge" his exposure to the movements of equity markets.

Shorting was a form or insurance, or hedge, against a drop in the market: hence the term hedge fund.

Today, however, the term covers thousands of different strategies including "long-short" funds that own some shares and sell others short, arbitrage funds that exploit small pricing differences across markets, and macro funds that can take huge bets on currency movements based on the manager's view of a country's economic position.

The divergence in strategies, hedge fund managers say, means that viewing them as behaving as a single class of asset or all sharing the same characteristics is profoundly misleading.

[FaGal]

Hedge fund secrecy hard to understand
news.ft.com - By James Altucher - March 14, 2005


Revisiting the Class of 1999, I initially had a different idea for this article. About a year ago I was helping a family office find some hedge funds. I started doing due diligence on a $10m fund but, for various reasons, put it on the backburner.

I continued to receive their monthly e-mails though, and each time I thought it was a fluke: up 23 per cent one month, up 18 per cent the next, up 27 per cent and so on.

In 2004 they were up 245 per cent net of all fees with no down months. And in the previous four years they did not have any down months. I missed it!

I figured it was too good to be true, it must be a scam. But it turns out they are returning all money to investors over the course of the next year, including all profits, before starting up their next fund. It is all legitimate and the cash is there.

So I called them and said I wanted to write about them. At first they were interested. But then they called back and said: “Our compliance officer said we can’t talk to you. We’re not allowed to publicise.”

So I said: “You're not publicising! You have no idea what I’m going to write about you. It’s not like it’s a paid advertisement.” But they refused to talk to me on the record.

Hedge funds are scared of their own shadows. Whenever there is an article about hedge funds, it is always about their “secretive” or “mysterious” world – like a new world order of cloak and dagger financial specialists, dividing up the world’s money supply between them. But the bottom line is these guys are scared of their own shadows.

They are scared to walk outside their doors and see press flashbulbs going off in their faces. Meanwhile, the $800bn mutual fund industry that primarily invests in only one asset class – long only US stocks – is running around scot-free under the cloak of regulation. Maybe they paid a couple of billion in fines when it came to letting investors trade late illegally, or in gaining larger IPO allocations. No problem. Hey, we’re regulated. Leave us alone.

While the hedge funds offer legitimate alternatives such as merger arbitrage, convertible arbitrage, distressed debt investing and specialty fixed income, their lips are sealed tight with duct tape and their hands are tied behind their backs.

If mutual funds are not always the best offering compared with hedge funds, what about ETFs such as the QQQQ (the Nasdaq 100 ETF) and SPY (the S&P 500 ETF)? Some money managers advocate putting money in “the market” and, since most mutual funds do not outperform the market, they might as well pick the lesser of two evils, the “passively” managed ETF. I put the word “passively” in quotes, because the reality is that these are pretty actively managed.

Take QQQQ, for instance. Every year there are between 20 and 50 additions and deletions on the Nasdaq 100, the index QQQQ represents. That is active trading.

In honour of the five-year anniversary of the Nasdaq 100 reaching its all-time peak in March 2000, I took a look at the Class of 1999 – the 30 stocks that were added to the index during that year. The nameless men and women who mastermind the index are always attracted to the front-page glamour stocks, adding companies such as internet incubator CMGI, Conexant and RF Micro Devices (all since deleted) in 1999 and throwing out the less fashionable AutoDesk, Lincare, Ross Stores (which sells clothes for people in their 50s – what was that doing in the Nasdaq 100?) and Stewart Enterprises (dreary funeral homes).

Let us say that, on January 1 2000, you bought all 30 1999 additions to the Nasdaq 100. It turns out you would have had 29 losing trades and only one winning trade – eBay, up 151 per cent. Many of the other plays – Global Crossing, Adelphia, @Home, and Metromedia – have gone the way of bankruptcy. Others, such as CMGI or Broadvision, are down more than 98 per cent. Overall, you would be 72 per cent down – even worse than the Nasdaq 100’s 62 per cent decline – saved only by eBay from complete destruction.

But the interesting returns come from the companies deleted from the index in 1999. At least five of the deletions were up more than 100 per cent. Ross Stores, for instance, is up 255 per cent since January 1 2000. Cracker Barrel Old Country Stores turned in a 357 per cent gain since being deleted from the Nasdaq 100 index in 1999. Even the technology stock Tech Data is up 52 per cent since being deleted from the index in 1999.

Which raises the question: should one always buy deletions and sell or short additions?

Let us take a look at the stocks that were added and deleted to the Nasdaq 100 index in 2004: stocks such as XM Satellite Radio (which lost $651m last year and has $1bn in debt) were added and Gentex ($500m in cash, no debt, $100m in cash from operations, steady growth) or Compuware ($600m in cash, no debt, and $227m in cash generated from operations) were deleted.

Are our old friends, the passive managers of the QQQQs, up to their old tricks? Time will tell.

[FaGal]

U.S. hedge funds eye loophole to avoid registering
www.reuters.com - March 18, 2005 - By Svea Herbst-Bayliss


BOSTON - Time is ticking away for U.S. hedge funds to prepare for their first-ever government regulation, but lawyers and managers say that many are spending hours working on ways to escape the additional scrutiny.

Beginning next year, thousands of the now loosely regulated and often secretive investment funds must tell financial regulators more by submitting to audits, adopting a code of best business practices and appointing a compliance officer.

Since the Securities and Exchange Commission adopted its new rule for hedge funds last year, registering as an investment adviser with the government has become an inevitable fact of life for thousands of hedge funds.

But plenty of managers may also steer clear of the costs and headaches they say will come with more oversight by taking advantage of one loophole the government left open.

"Virtually every one of our clients is now evaluating whether to register or to take steps to avoid it," said George Mazin, a partner at law firm Dechert LLP.

A LONGING FOR LOCKUP

Funds with more than $30 million in assets and 15 or more clients will have to fill out the paperwork and thousands of managers fall into this category, industry experts said.

However, hedge funds that agree to keep their clients' money for at least two years are not required to submit to the registration process.

Suddenly, a large number of managers are considering much longer lockup periods.

By hanging on to their clients assets for longer, the managers can avoid documenting their investment procedures and sticking to everything in that manual.

They can also avoid certain compliance training, having to keep reams of data for auditors and testing and monitoring their employees more closely.

All of these things cost time as well a considerable amount of money, industry experts said. Law firms charge $30,000 for tailoring a manual to their client's fund and compliance firms charge about $50,000 per year for spending several days a month at a hedge fund making sure all documents are in order.

"Some people are looking to avoid registration because the costs are not insignificant," said Emmett Ryan, director of hedge fund services at compliance firm Buchanan Associates, who will meet with 11 hedge funds in the next two weeks to go over the basics of preparing for next February's deadline.

"A lot of people come see us to shop around and I would not be surprised if the two-year lockup periods now becoming popular didn't find their roots in the registration process," he added.

SEC MAY NOT BE AMUSED

Already, roughly one third of the world's estimated 8,000 hedge funds are registered with regulators, and only a certain type of fund will be able to take advantage of the loophole, lawyers and managers said.

"A manager has to have delivered really good returns to be able to tell clients that they won't see their money for two years at a time many of the pension funds are demanding to get their money back every month, if they don't like the hedge fund's performance," said a manager, who asked not to be named.

The loophole "is an avenue that is available and clients seem eager to take advantage of it," Dechert's Mazin said.

The SEC, however, has already signaled that it won't tolerate any abuse of the lockup provision.

Paul Roye, director of the SEC's Division of Investment Management, warned several times that the rule might be redefined if significant evasion is seen.

"The SEC is determined and they are not going to be spooked or made a fool of," said Charles Gradante, principal of the Hennessee Group, which helps clients invest in hedge funds.

"The SEC isn't going to allow a loophole to impact the kind of registration they want. If it happens, they will just close it off."

[FaGal]

Written in 2004 but valuable background.

Hedge Fund Strategies Combining Futures & Options

By John Person, Infinity Brokerage Services

Source: CBOT

It is often said Bulls make money, Bears make money and Pigs get slaughtered, and sometimes spread traders take all of the money home!

In essence that is what hedge funds do at times - spread or hedge their investments in the derivatives markets. Fund managers know how to leverage their leverage and manage risk by knowing exactly how to spread off positions and parlay profitable trades into huge winners.

Commercials are hedgers, they are using the derivative markets to reduce or eliminate risk. Speculators, on the other hand, accept that risk in return for big gains. Hedge funds, or large speculators, apply every technique in the realm of trading strategies to earn above average returns by implementing risk management trading tools.

Spreading and the use of option strategies are just a few techniques used by hedge funds that can achieve these goals for the highest maximum returns with better risk controls.

The purpose of this article is to heighten your awareness to the various strategies, and to illustrate how professional traders, specifically hedge funds, utilize options as additional income trades by writing options to collect the premiums against underlying futures positions. In addition, it will show you how they use options to hedge against adverse risk by using time to their advantage. Strategy examples will be giving using CBOT's new 100% electronic mini-sized Dow options.

Let me share with you some insights in the hedge fund world. In 2002, it was estimated that approximately $600 billion was invested in hedge funds, mostly because of strong performance and the sophisticated trading tactics used to trade money. Hedge fund managers can use any style and asset class. That gives them a lot of flexibility.

Historically, hedge funds do well in bear markets. In 1987, the year of a stock market crash, hedge funds returned 14.49 percent compared to an S&P 500 return of 5.24 percent. Part of that performance is attributed to the ability to short, or bet against, stocks.

Billionaire Warren Buffett, who some say is one of the world's smartest investor, is reported to have some of his personal fortune invested in the Bermuda-based hedge fund, West End Capital Management.

Unfortunately, there is a whole set of SEC rules and regulations written to keep smaller investors from participating in a hedge fund. According to the SEC rules, to invest in a hedge fund, investors must have an annual income of $200,000 if you're single and $300,000 if you're married.

Hedge fund managers are not restricted to a set style or disclosure of which derivative markets they use. In fact, they can short the market and often times use a basket of stocks known as exhange traded funds or ETF's and stock index futures. This style is in contract to that of mutual funds, which mainly are fully invested in stocks, bonds or in cash, and usually hold to the business model of being long the market.

Hedge fund pros know how to use equity options positions to generate extra income without selling. Some strategies include writing covered puts and calls, calendar spreads, collars, cross-market spreads, curve trades and synthetic futures option strategies.

These strategies can be a combination of just option positions or a combination of futures and options together. Remember that options are complicated to those who do not educate themselves on the subject. It takes time and practice. In fact, trading is complicated, life is complicated. The great thing about our society is that we have power. Each and every one of us has power. That is, the power to make choices and decisions. We have the power to want to explore and expand our knowledge in any subject. If you are a trader you have the power to learn more about investing.

In the beginning of this article I stated that commercials are hedgers and they typically use the derivative markets, in this case the futures and or options markets, to reduce or eliminate risk.

Speculators, on the other hand, accept risk in return for potential gains. Most investors do not have a risk plan other than a stop. That can be a real order or a mental idea of where to exit a trade. The later is the worst as most speculators change their minds and thus can fall into the trap of letting losers ride.

I want to introduce you to the concept of implementing option strategies as a hedging vehicle, or an insurance policy, which can put you on the same level as a commercial or professional trader. After all, if a bank uses futures to spread off risk, why can't a futures trader use options to spread off risk and act like a hedger?

Hopefully this article will dynamically alter your perception and understanding of options. On the one hand, options trading can be a complex dimension and new universe due to the fact that options have many variables and there are so many choices to make. On the other hand, that is why they offer flexibility.

Options are multi- dimensional. There is more to calculating the options value besides determining an opinion of the direction of price on the underlying market. As we know, markets only have three choices to move: up, down or sideways.

With options there are other elements to consider besides picking the right price direction. There is time and volatility to consider. Volatility is not just categorized as the change in price value, but also as the measurement of the percentage change in price. There is implied volatility and historical implied volatility.

There are ways to hypothetically measure an options value by mathematical models as developed by University of Chicago's Fisher Black (mathematician) and Myron Scholes (economist). They developed the formula that is standard in the pricing of options value.

Then there are other elements to help calculate various value changes, known as the "Greeks". For example, delta gives the percentage value the option will move in relation to the move in the underlying market. Theta gives the value change against time decay. Vega measures the options price value on the change in volatility. Then there is gamma, which measures how fast the delta will change.

Directional trend strategies in options if one is bullish can include outright purchases of call options. This carries the characteristic of limited risk with unlimited rewards. There are many other combinations one can implement such as bull call spreads, ratio back spreads, vertical or horizontal calendar spreads. As you can see there are many names and variations one can mix and match to custom tailor a trading plan. The bearish strategies would use the opposite of these nomenclatures such as outright put purchases, bear put spreads and so on.

One specific strategy I wish to discuss is what is known as a "Collar". A collar is designed to reduce risk without putting your money up for protection. This is done by writing and buying an option against a futures position. The downside of this strategy is that it reduces your profit potential. It is a hedge strategy within a specific price target range.

For example, on 04/07/04 the mini-sized Dow was trading between 10465 and 10500. If you were to take a bullish bias on the market as a position trader, one could go long futures at 10480, the midpoint of that session, and one could sell the 10800 calls and collect 113 points. This would be considered a covered call option strategy. Seeing as the contract high is 10750, if you are bullish but do not believe the market will advance much beyond 10800 within the 71 days, which was the time of expiration as of that date. In essence, you will have 113 points the premium collected plus the difference between 10480 and 10800, which is 320 points, for a combined total profit potential of 433 Dow points. As you can see, your profit potential is limited. In fact, with the premium collected you cap your gains at the time of expiration to 10913 (10480 plus 433 points = 10913). But are your gains really limited within terms of likely probabilities? The likelihood of a sustained rally much above 10913 over the next 71 days is a small probability as that would be close to a 4.5% price appreciation. That would be considered a big move for the Dow in a short period of time if the market did rally.

What about the downside risks? That is the biggest concern. What happens if the market has a violent sell-off, would a stop help protect you? In extreme cases most likely not. In rare situations such as a market crash, the income from selling the out of money call (while it is nice to add the money collected to your account) would certainly not help offset disastrous losses one would absorb in the futures position.

Here is where the collar strategy comes in. Why not apply that premium you collected to purchase a put option close to the money to help reduce your risk exposure in the market?

At the same time, you would have sold the 10800 call the 10400 put had a premium of 243 points. As you can see, the entire cost of the premium would not be covered, rather it would reduce the amount you pay out of pocket. So instead of paying 243 points your cost would be 130 points (243 - 113 = 130). Plus the risk between 10400 strike and the 10480 futures position your net loss amount would be 210 points (130 + 80 = 210).

This strategy reduces your overnight margin requirement to 210 points, which at $5 per point is $1050. This reduces the initial margin requirement by over 60%, allowing you to utilize your trading capital elsewhere. The initial margin requirement for an outright futures position on the mini-sized Dow is $2,500.

One may ask, why not just buy the call option? Well, that can be a consideration but due to time decay even if the market does rally up to 10913 for instance at expiration, simply buying the call option would just break you even rather than actually make money. Think about this - the market would move nearly 433 points and if it settled at 10933 at expiration, at best all you would do is break even before commissions and fees.

Due to the time element and the nature of the value depreciation of an option (meaning it can only go to zero as a buyer) options used as a hedge device can give one a better opportunity under certain market conditions. Forecasting a price move within what I call the "realm of reality" will give a trader a better handle of what the target frame a price move may take. As the example above illustrates, a bullish trader has good reason to think the market could rally and trade above the 10750 level and get beyond 10800 within 71 trading days. On the other hand, could a watershed event cause a disastrous plunge in the stock market and wipe one out? Yes, there are events, as we have learned in the past, that can cause such a move.

If one has a good idea of which direction the stock market may go and wants to participate in a position trade utilizing the futures markets, then a collar strategy may be the right choice that will limit losses and offer a reasonable profit potential.

The exceptional part is that the CBOT implemented market makers to provide liquidity in the options market on the mini-sized Dow so it is all electronic. In fact, on Thursday, April 8th, the CBOT mini-sized Dow options hit new records in volume and open interest, trading 3,478 contracts and posting open interest of 12,138. Volume and open interest is growing almost on a daily basis as more and more investors learn about this exciting product.

Now, individual investors can participate with a great trading vehicle on the benchmark stock index that adapts to changing times. For example, the Dow Jones Industrial Average was refigured at the start of trading April 8, 2004, with three new components, telecom leader Verizon, insurance giant American International Group, (AIG) and drug company Pfizer. Removed were AT&T, Eastman Kodak and International Paper.

The importance of these events is that the DJIA has 30 stocks to follow and these three stocks add billions of dollars of capitalization to it. This makes the market susceptible for events which accelerate the momentum of a specific direction, giving futures and options traders flexible ways to take advantage of the market. Using CBOT mini-sized Dow options, one can construct a position with almost any kind of a performance curve.

Other beneficial features of Options:

Options can be used not only as a speculative position but also as a hedge and or a way to stimulate increased income from a trader's portfolio.
Since we all realize that stress is bad for traders, as it leads to poor judgment, option strategies can help to alleviate stress and provide the emotional edge to stay with a trade, or better yet, give the trader the courage to enter into a trade.
A wrong prediction will result in a loss, which, with options can sometimes be minimal compared to a misstep in the underlying futures contract.
Many option software programs have built in theoretical scenarios one can plug in to figure the "what if" concept.
Rules to trade options by:

Buy options with at least twice the life expectancy you think you need or that it will take for the market to move. In other words, double up on your time frames. Most traders are right in their thinking but wrong in their timing.
Choose option strike prices that are within the realm of reality in a given time period. For example, if you are bullish the equity markets in April and feel the Dow may rally by year's end, then setting a target of 11,500 may be realistic to buy out-of-money calls, not 12,500.
As an outright premium buyer risk half the premium or half the time value and reevaluate the markets condition at that time to see if you still hold the same opinion on the market. It is at that point you may want to think about cost averaging or selecting closer strike prices to your account.
Remember what "fair value" really means - neither the buyer or the seller has an advantage. Learn to judge whether you are buying options on the high side or selling premium on the shy side.


Want to know more?

Participate in a LIVE ONLINE SEMINAR with John on 4/14/04 @ 3:30 PM CST.

Submit a question to the author of this article (please include "Person Strategy" in the question).

Interested in other trading strategies?


--------------------------------------------------------------------------------

About John Person
JOHN L. PERSON is a 22 year trading veteran and a registered Commodity Trading Advisor with Infinity Brokerage Services. He publishes The Bottom Line financial and futures newsletter and hosts his own financial radio show where he interviews some of the country's top analysts and traders. These interviews are archived on his web site, www.nationalfutures.com . He is widely quoted by CBS Market Watch, Reuters, Dow Jones Newswires, Bloomberg, the BBC, Futures magazine, and appears as a guest on CNBC. He teaches trading techniques at some of the country's leading investment expos and conducts seminars from coast to coast. He writes his daily market commentaries, which can be found in the Dow Trading Resources section of www.cbot.com/dow, the Chicago Board of Trade's website. He is the author of the recently published book A Complete Guide to Technical Trading Tactics: How to Profit Using Pivot Points, Candlesticks, & Other Indicators, John Wiley & Sons.



If you trade CBOT DowSM futures and options and are interested in submitting a strategy for publication on the CBOT Web Site please contact us.

The information in this commentary is provided from sources believed to be reliable, but the Chicago Board of Trade does not guarantee its completeness or accuracy. The opinions expressed within the commentary may change without notice. The commentary was prepared for general circulation and does not have regard for the particular circumstances or needs of any specific person who may read it. Neither the information nor any opinion expressed in the Commentary constitutes a solicitation for the purchase or sale of any futures or options contracts.

[FaGal]

If I Only Had a Hedge Fund
By JENNY ANDERSON and RIVA D. ATLAS

IT seemed like an ordinary evening at Crobar, the trendy Manhattan nightclub. Two weeks ago, as Counting Crows performed on stage, young women dressed in expensive jeans pushed toward the front with their khaki-clad, mostly older boyfriends. Few, however, were regulars. On this night, the very rich and the merely rich intermingled on the club's two floors - V.I.P.'s upstairs ($1,000 a ticket) and the rest down below ($250).

Most of the 1,250 people gathered for the event, the Robin Hood Foundation charity ball, were part of the city's unlikely new "it" crowd. Richer than Wall Street rich and more willing to take risks than their traditional money management peers, they are the managers behind the staggering growth in hedge funds, those private, lightly regulated investment vehicles aimed at the ultrawealthy, the run-of-the-mill wealthy and, increasingly, the not-so wealthy.

To critics, the frenzy has a very familiar ring. A flood of capital to the latest investment fad. Spectacular accumulation of wealth in a short time. New ventures created easily and often. Those, too, were the hallmarks of the dot-com boom, and, as everyone knows, the bursting of that bubble was far from pleasant. The stampede to hedge funds, some people fear, will be no different.

"It is completely obvious that this will end badly - for the firms, investors, everyone," said Seth Klarman, founder of the Baupost Group, which manages $5 billion. "No area of financial endeavor is immune from the effects of competition."

The numbers are mind-boggling: 15 years ago, hedge funds managed less than $40 billion. Today, the figure is approaching $1 trillion. By contrast, assets in mutual funds grew at an impressive but much slower rate, to $8.1 trillion from $1 trillion, during the same period. The number of hedge fund firms has also grown - to 3,307 last year, up 74 percent from 1,903 in 1999. During the same period, the number of funds created - a manager can start more than one fund at a time - has surged 209 percent, with 1,406 funds introduced in 2004, according to Hedge Fund Research, based in Chicago.

In a way, hedge funds are to mutual funds what Evel Knievel was to weekend motorcyclists. Unlike mutual funds, which are restricted in the ways they can invest, hedge funds can use leverage, trade derivatives and bet that stocks will fall, a technique called shorting. And unlike mutual funds, which generally try to beat a market average, hedge funds seek positive returns, even in down markets.

THE meteoric rise of hedge funds has had a huge impact on the markets, investment banks and investors, who increasingly include institutions like pension funds or endowments. A recent report published by Credit Suisse First Boston said that hedge funds were responsible for up to half of all activity in major markets, including the New York Stock Exchange and the London Stock Exchange.

Investment banks are tripping over one another to service them. According to the same report, Wall Street made $25 billion catering to hedge funds - lending them money, trading for them, helping to structure complex derivative transactions or lending them stock to bet against a company. That's one-eighth of the street's total revenue pool.

Signs that hedge fund managers have become the financial industry's new elite abound. Young, ambitious talent is fleeing Wall Street in search of hedge funds' overnight riches. In hedge fund offices, employees have perks like swimming pools and basketball courts. And in the wedding announcements of The New York Times, hedge fund managers are often well represented.

At cocktail parties throughout Greenwich, Conn. - the informal capital of the hedge fund world - investors sip apple martinis and discuss which funds are in vogue. Because few people outside the industry know exactly how they trade or what they trade, there is a certain mystique to the hedge fund set, which only adds to their allure.

Then there's the wealth effect. Billionaire hedge fund managers are pushing up the price of everything from luxury apartments to artwork. Kenneth Griffin, founder of the Citadel Investment Group, based in Chicago, dished out $60 million for a Cézanne. James G. Dinan, founder of York Capital Management, paid $21 million to buy the Fifth Avenue apartment of $6,000 shower curtain infamy, the one once occupied by L. Dennis Kozlowski of Tyco International.

Predictably, most people in the hedge fund world scoff at the notion of a bubble. "Hedge funds are not an asset class, so there is no asset class to burst," said Jane Buchan, chief executive of Pacific Alternative Asset Management, a fund made up of hedge funds with $7.2 billion under management. "It's not like real estate. Even if you think about people doing silly things for silly reasons, it's not a bubble. If you look at people traveling on the fringes, it might be a bubble."

Indeed, the so-called smart money - rich investors like Thomas H. Lee, the famed leverage buyout maven - could not seem less worried. "Every investment board I am in touch with is interested in hedge funds," said Mr. Lee, ticking off the names of such giants as Calpers and Harvard's endowment fund. Mr. Lee himself has invested a substantial portion of his estimated $1.2 billion net worth in a portfolio of dozens of hedge funds.

Yet, as Mr. Klarman said: "How many venture capital investors in 1999 said, 'We are doomed because of all the money flowing in?' "

Whether the hedge fund boom is a bubble may still be open to debate. But it is certainly not alarmist to wonder about the consequences of such torrid growth, built as it is on the leverage that banks provide managers to double or triple their bets. The Federal Reserve seemed concerned enough last fall, when it set up a group to examine what systemic risks had been created by the explosion of entrants into the market and the aggressiveness with which Wall Street was welcoming them.

The Fed also encouraged the revival of a high-profile watchdog group formed in the wake of the market-shaking 1998 collapse of the Long-Term Capital Management hedge fund. Called the Counterparty Risk Management Policy Group II, it will examine everything from narrow credit spreads - a result of low perceived risk - to the cavalier ways that Wall Street lends to hedge funds.

"Hedge funds are significant market players," Stephen M. Cutler, director of enforcement at the Securities and Exchange Commission, said in an interview. "They use leverage that mutual funds cannot, so the power of that $1 trillion is magnified. Your concern is not just the investors in the hedge funds but the hedge fund's impact on the market."

To impose a modicum of order on the industry, the S.E.C. has required that most hedge fund management firms register as investment advisers by February 2006, a move that an industry trade group has protested.

CONCERNS about hedge funds, however, extend beyond finding out where they are based and whether their managers are felons (two of the objectives of S.E.C. registration). Among other things, it remains a mystery - even to investors - what kind of bizarre financial products are traded by the funds, and how they value them. Given the potential returns, the incentives for investors to bet the house are huge. And many seasoned money managers have closed their funds, opening the door to newcomers to satisfy demand for ever more funds.

Perhaps topping the list of concerns is the proliferation of funds of funds, pools of hedge funds that are meant to lower risk but that also come with another layer of fees on top of what standard hedge funds charge. By the end of last year, assets in funds of funds had soared to $359 billion, from $84 billion just four years earlier. Traditionally, investors have needed a minimum of $1 million to get into a hedge fund; with the newest funds of funds, investors with as little as $25,000 to spend can gain entree.

Hedge funds may hit Main Street in other ways. At least one fund of funds, Grosvenor Capital, with $15 billion under management, is weighing an initial offering or a sale, people close to the company said.

Hedge funds are the new blackboards on which dreams of high finance are drawn. For Karim Samii, who enjoyed a successful career at the investment firm W. R. Huff of Morristown, N.J., the decision to start his own hedge fund came on a bright, snowy morning in December 2003, when he and his wife were visiting his in-laws in Hamburg, Germany. "I was jogging around the lake and I said to myself, 'Where do I want to be five years from now?' " he said.

His firm, Pardus Capital, will open for business on April 1. "It's a big bet," said Mr. Samii, 42. "But if you think you're good, you take the risk."

Philip Broenniman, a 39-year-old trader, spent five months in 2003 cobbling together $20 million to start Cadence Investment Partners in New York. In late October, a week before his firm was set to open, two investors pulled $13 million. "We opened our doors with just $7 million," he recalled. A year later, after posting 16 percent gains, the fund has grown to $119 million.

Managers of funds of funds and other entities that invest in hedge funds say they are overwhelmed by the numbers of start-ups. "We saw 600 pitches last year," said Ted Seides, director of investments at Protégé Partners in New York, which invests in new hedge fund firms. Of that number, he said, Protégé ended up backing just nine. "There are a lot of hopes and dreams," he said. Of course, not all dreams come true.

Ask new managers why they are starting funds and the answers often recall the late 1990's: to build something, to test the "pure art of investing," to be an entrepreneur. One two-year industry veteran with $60 million under management describes why he did it: "Because I could."

Even hedge fund experts who pooh-pooh the notion of an investment bubble acknowledge the possibility of a compensation bubble. Instead of just receiving a fixed percentage of the funds they manage, hedge fund managers generally make "1 and 20" - that is, 1 percent of assets under management and 20 percent of profits.

To put that in context, a mutual fund company managing, say, $100 million and earning 1 percent of assets under management makes $1 million. By comparison, a hedge fund making the 1 percent management fee and a 20 percent "carry" takes in $1 million for opening the doors, and an additional $10 million if the fund returns 10 percent. That's $11 million in revenue.

"Hedge funds are an innovation of compensation," said one fund-of-funds executive. "It's a compensation system, not an asset class." The comment is meant to be positive: in hedge funds, compensation is aligned with absolute performance. In the mutual fund industry, by contrast, compensation is usually tied to performance against a benchmark, like a Standard & Poor's index, or assets under management.

Will fees come down? Few people think so. "If you lower your fee, they think something's wrong with you," said one longtime manager who described the fees as "absurd."

In fact, fees have been moving higher. When Carl C. Icahn, the famed takeover trader, raised a $2 billion fund last year, he demanded 2.5 percent of assets and 25 percent of the profit.

In 2003, the 25 highest-paid hedge fund managers earned more than $200 million, on average, according to a survey by Institutional Investor magazine. The top-ranked manager, George Soros, took home $750 million that year. At No. 2 was David Tepper, manager of the $3 billion Appaloosa funds, who earned $510 million, according to the magazine.

The lure of hedge funds, of course, is not supposed to be the high pay but the outsized returns. Lately, the results have been less than compelling. Over the 10-year period that ended last December, hedge funds had an average annualized return of 12.57 percent, according to an index maintained by Hedge Fund Research. That is just slightly ahead of the 12.07 percent return of the S.& P. 500 during that period, though hedge funds earned their return with half the volatility.

During the market downturn, however, hedge funds did hold up well. In both 2000 and 2001, for example, the average hedge fund rose nearly 5 percent, according to Hedge Fund Research. That compares with declines of 9 percent in the S.& P. 500 in 2000 and nearly 12 percent the next year.

IN 2004, however, the average hedge fund rose around 9 percent, lagging behind the S.& P. by nearly two percentage points, Hedge Fund Research has reported. During the first two months this year, the latest data available, hedge funds were up nearly 2 percent, compared with a flat return for the S.& P.

Many in the industry say the sharp increase in both supply and demand won't destroy the fundamentals of the business. "It is so much the better way of managing money," said Julian Robertson, who got out of the business five years ago after forging a reputation at Tiger Management as one of the most successful hedge fund managers. Today, he keeps a hand in the industry by providing seed money to new hedge funds. "Hedge funds have had about a 10-year place in the sun," he said. "I don't see any reason for that to stop."

Many industry veterans say the party will continue, partly because of the shift in who invests in hedge funds. As recently as 2000, hedge funds were almost exclusively for the very rich. Now institutions want a piece of the action. Pension funds and other institutions are expected to invest as much as $250 billion in hedge funds over the next five years, according to a recent study by the Bank of New York and Casey, Quirk & Associates, a consulting firm. That would ultimately account for half of all money flowing into hedge funds.

But as the pension money comes in, hedge fund returns are likely to go down, as fund managers adapt their strategies to suit the new clientele. Pension funds prize predictability over outsized returns; the average pension fund is looking to make just 8 percent, net of fees, on its hedge fund investments, the Casey Quirk report concluded. That is a far cry from the 25-percent-plus returns generated by rock-star managers like Mr. Soros and Michael Steinhardt.

A possible check on hedge funds is the simple fact that while anyone can start one, the industry has a high casualty rate - especially for the smallest funds, which struggle to attract and keep investors. Untested managers whose returns languish often see their capital flee and are forced to shut down.

"There are very low barriers to entry but very high barriers to staying in business," said Philip Duff, chief executive of FrontPoint, a $4.3 billion hedge fund, citing the average annual life of a hedge fund of 3.5 years. "That's problematic for investors," he said - particularly institutional investors who do not relish moving money around.

"There's a reasonable probability a hedge fund will have a significant problem," Mr. Duff added. The fund, he said, "will be high-profile, and the question is, if and when that happens, does it materially change the growth in demand? My answer is no."

While new funds have flourished, seasoned managers are also absorbing the demand generated by institutions. "In 2004 we saw nine $1 billion-plus start-ups, and 2005 is on track to outpace that number," said Gerard Coughlin, a head of Morgan Stanley's prime brokerage services. "While the high-profile start-ups command great attention, many established managers are busy broadening their product offering and expanding their footprint. The capacity created by these proven managers and high-profile start-ups is effectively raising the bar on what it takes to be successful as a new manager."

Longtime hedge fund investors have faith in the power of Darwinism. "It will be survival of the fittest," said Michael Price, former manager of the Mutual Series mutual funds, who now invests $1.6 billion - a good chunk of it in hedge funds - on behalf of family, friends and two college endowments. "The guys who are not creative or don't know what they are doing won't last."

That is not to say that there is anything stopping them from starting up - and potentially losing investors' money. "There's zero shame involved in launching a fund and failing," said one fund of funds manager who, like many executives in the ultrasecretive hedge fund universe, asked not to be identified.

INDEED, it is not unusual for managers to get a second chance. William A. Ackman once ran Gotham Partners, one of the most successful hedge funds in the 1990's, boasting a list of blue-chip investors that included the Ziff family and Martin Peretz of The New Republic.

By the end of 2002, Mr. Ackman and his business partner, David P. Berkowitz, were forced to shut the fund after they became stuck in a private equity investment they couldn't sell, and some investors demanded their money back. Since then, Mr. Ackman has raised $410 million for a new firm, Pershing Square; he has promised investors in his new fund that he will not make private equity investments.

In the same way that there is no quelling the bulls, there will be no quieting of the critics. The Horvitz family of Cleveland, which made its fortune in road construction, media and real estate, started investing in hedge funds in the 1990's. A decade or so later, it has virtually no money in such funds, said Jeffrey Horvitz, who oversees his family's investments. Too often, he said, the funds produced disappointing returns.

"Hedge funds are no longer attractive," Mr. Horvitz said, noting the influx of start-ups. "I see no relief in sight, especially for taxable investors like us."